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Cambridge Economics

News from the Faculty of Economics Issue 11 Winter 2018 A Good Knight’s Work Distinguished Alumnus: Professor Sir *

Angus Deaton was awarded the 2015 in Economic Sciences for ‘his analysis of consumption, poverty and welfare’. The citation for his UK knighthood, conferred the following year, was for ‘services to research in economics and international affairs’. Following and , both of whom were friends and the latter his closest mentor, and after and James Mirrlees, who spent much of his career at Cambridge, Angus is the fifth Nobel Laureate from Cambridge economics.

Cambridge life No-one, including Angus, could have foreseen this outcome when he first came to Cambridge in 1964, from Fettes College in Edinburgh, to read Mathematics. He says he found the subject, as taught, difficult to engage with: he lost interest; played lots of bridge and went to the cinema; did very little work; discovered Cambridge pubs, and consequently fared badly in INSIDE: examinations. From the Editor 3 Professor Sanjeev Goyal 4 By the end of his second year he was on the point The Education Production Function: A Brain Teaser 6 of giving up and leaving Cambridge. But his tutor at The Narrow Corridor to Liberty 8 Fitzwilliam College who, like his father, was anxious to Morality and the Market 10 keep him in the College, persuaded him otherwise, GDP – Grossly Distorted Picture? 12 saying: ‘There is only one thing for people like you – Better Economics Teaching? CORE! 13 Economics!’ The Digital Revolution and the State: The Great Reversal 14 The Economics of Religion in India 15 Systemic Risk-shifting in Financial Networks 16 Continued overleaf... Awards / Obituaries 18 Comings and Goings 20 Distinguished Alumnus

Transferring to Part 2 of the in the Coffee Room. But there were model maintains Slutsky symmetry Economics Tripos, Deaton graduated helpful people: Deaton remembers in price responses, as well as the in 1967. He went to work in the Ken Wigley, who was to move later homogeneity condition that, if (embryonic) research department of to the OECD, and Gwyn Aneuryn- prices and income both increase the Bank of England. But his mind Evans, who was starting to bring by the same percentage, the was elsewhere: he had a girlfriend econometrics into the Faculty. And, consumer’s ideal bundle of goods who was a doctoral candidate above all, the coffee was good – for consumption will remain in English at Cambridge, and he specially brewed and served by the unchanged. wanted to come back to get married. concierge’s wife. This model, the origins of which In 1969 he was appointed as a Junior In association with his University can be traced back as far as the 19th Research Officer in the Department post, Deaton became Fellow and century, had been the object of of Applied Economics, working Director of Studies in Economics criticism, mainly on account of its on national wealth accounting at Fitzwilliam in 1972, where he restrictive assumptions. By building data in collaboration with Dr Jack remained until 1976, when he was large and detailed databases – a Revell, who was writing his book on appointed to a Chair in Econometrics very big manual task in those days ‘The Wealth of the Nation’ and had at Bristol University. He moved to – Deaton was able to disaggregate been Deaton’s Director of Studies Princeton as Professor of Economics the consumption function so as to at Fitzwilliam. One of Deaton’s and International Affairs in 1983 model heterogeneous consumer tasks was manually to derive and until he became Emeritus in 2016. behaviour, in the context of prepare data held at the offices of Currently he is Senior Scholar in relative price movements among the Registrar of Friendly Societies – a the Woodrow Wilson School at commodities with different income lengthy and tedious assignment. But Princeton. and substitution effects. The it involved interacting directly with outcome – the ‘Almost Ideal Demand primary data which, he says, led him Knight work System’ - gave a rich insight into to start ‘dreaming about numbers’ Deaton’s work has focused on the consumer behaviour, and made and what they might reveal. patterns and drivers of consumption possible the rebuilding of aggregate in developed and developing demand functions to demonstrate When Revell left Cambridge for countries, the form and analysis of that, rather than being wrong, the a Chair at Bangor, in North Wales, the consumption function (linking standard theory had been mis- Deaton became involved with the income to aggregate demand), specified in practice. Growth Programme, led by Richard and the relationships with income, Stone and who was himself to poverty, health and welfare. Deaton’s attention then turned to become a Nobel Laureate in 1984. the study of consumption over time, Deaton worked with Alan Roe on At Cambridge, Deaton, following and the part played by income and ‘Finance for Growth’, concentrating and working with Richard Stone, wealth. The permanent income/ on ‘saving and consumption’, inherited Keynes’ concept of the life-cycle theory argued that which proved to be the start for his aggregate consumption function as temporary variations in income lifetime’s work on human wellbeing. a main driver of economic activity. will lead to individuals adjusting On the pattern of demand, one of their short-term savings behaviour Looking back at life in the Economics Deaton’s early contributions (with so as to smooth their long-term Faculty, Deaton recalls the Coffee John Muelbauer, then at Birkbeck) pattern of consumption to match Room (Faculty Lounge) being was to demonstrate the usefulness their expected long-term income. dominated by Nicholas Kaldor and for empirical work of the standard Moreover, if individuals are rational , larger-than-life neoclassical theory of consumption. and have good information, guardians of the Keynesian legacy. This took as granted the rationality permanent consumption will move It was not easy for newly-recruited of the consumer in seeking to towards equality with permanent junior academic staff to get access maximise individual utility, and in income. Real-world aggregate to them: they were surrounded by Deaton and Muellbauer’s work, data appeared to confirm these their acolytes and had little time for allowed for limited but interesting relationships. young researchers from the DAE. heterogeneity across individuals, Richard Stone and James Meade, while producing an empirically But Deaton showed that this is by choice, did not engage socially tractable model of demand. The misleading if, as in the textbooks, it

2 is interpreted as the behaviour of people out of poverty. A degree of a representative agent. If a single income inequality is necessary to From the Editor agent were to receive average reward effort and innovation. He has income, and behave rationally, brought all this together in his book consumption should be less smooth ‘The Great Escape’ (2013)**. It is an exciting, if controversial, time to be an than income, what became known . There are two major issues: the as the `Deaton Paradox.’ The moral is Recently, in association with state of Economics and economic research; that we have to work with individual Princeton economist (and Angus’s and the state of economics education. agents, not mythical representative wife), Anne Case, he has studied the agents, and that we must model causes of the trend to increasing For the first of these, the charges against conventional microeconomics are that it is realistically what they know and mortality and morbidity among mid- dominated unduly by mathematical models; when they know it. The enduring life white non-Hispanic Americans it lacks empirical relevance, and it fails to take significance of this is to demonstrate with low levels of education (that is, account of developments in cognate subject the importance of evidence-based, High School or less). It is associated areas - psychology, sociology, biology and history finely-grained and comprehensive with increases in drug overdoses, in particular. At the same time, macroeconomics empirical data at the level of suicides and alcohol-related liver is seen as needing to rebuild its intellectual households to make possible the disease. While stagnant real wages architecture after having been unsettled by the re-aggregation of the consumption and the loss of job opportunities financial shock of a decade ago. For the second function – something which the are clearly relevant, the underlying issue, there are lively debates about the scope of the digital revolution and recent work in causes go much deeper: Economics curriculum and its relevance for today’s macroeconomics is helping to carry households in this segment of the students, and about pedagogic philosophy and method. forward. community suffer cumulative inter- generational disadvantages in labour Economics in Cambridge is closely involved in Economic growth and the market opportunities, in marriage pursuit of happiness all of this. Some aspects of what is going on is and child outcomes, and in health. reflected in this year’s issue of Cambridge Economics. This work led on naturally to The challenge demands effective Sanjeev Goyal’s valedictory at the end of his four considering the links between policy interventions: reducing years as Chair of the Faculty shows the outstanding income and poverty. Here, in excessive prescription of opioids is contribution he has made to the development of addition to developing frameworks one; supporting increases in median research and teaching in Economics in Cambridge. for the identification and real wages is another. Matthew Elliott’s review of his own work on risk- measurement of poverty, Deaton shifting in financial institutions is a fine example fully accepts the role of economic Reflecting on current economic and of contemporary empirical research, just ten years since the collapse of Lehman Brothers. Diane growth in alleviating poverty in social trends, Deaton notes emerging Coyle, who contributes much to the debate on the poor countries. But the respective evidence among the millennial roles of growth and redistribution reform of Economics education, shows how insight, generation of discontent towards analytical precision and the Big Data revolution are hopelessly muddled in the large multinational corporations, can alter our understanding and interpretation data by the fact that household carrying implications and challenges of fundamental economic indicators. Above all, surveys, which are used to calculate for their business strategies. This perhaps, Nobel Laureate Angus Deaton’s life-time distribution, are often wildly forms part, perhaps, of a broader work and achievements demonstrate the symbiosis inconsistent with the national platform of doubt about the values between economics research and teaching. accounts statistics, which measure of both capitalism and democracy. growth. Debates about growth If this is so, he sees it as vital for This issue, in addition, marks significant publications by colleagues and summarises the key public versus redistribution can never democratic systems to deliver for lectures that have been given in 2017-18. The be settled because debaters can the majority of people, rather than circulation of Cambridge Economics is amongst the essentially choose their own data to dedicated and active minorities, buttress their cases. largest of all alumni newsletters in the University. if economic and social welfare We value the interest and support that comes (‘happiness’) is to be improved. Deaton recognises and celebrates the from across the whole range of alumni/ae. We are always happy to hear from you at www.econalum@ importance and long-term benefits Tony Cockerill hermes.cam.ac.uk. of economic growth, which through * Interview took place on 4 July 2018. international trade and integration is Prof Tony Cockerill ** Angus Deaton (2013). ‘The Great Escape: associated with innovation, improved health, wealth and the origins of inequality’. 27 September 2018 health and welfare, and with lifting Princeton University Press.

Cambridge Economics Issue 11 Autumn 2018 3 Professor Sanjeev Goyal

Professor Sanjeev Goyal looks back on his time as Chair of the Faculty of Economics

There is nothing so rewarding as to work closely with extraordinarily gifted colleagues in the pursuit of a shared vision.

took over as Chair of Faculty programmes very poorly (relative Plan for the Faculty. The Plan was on October 1, 2014 and to assessments of other Cambridge approved by the General Board of am stepping down after a degrees). So teaching became the University in November 2016. four-year term, at the end of the focus of our efforts. I worked this September. closely with Professor Alexei Onatski The document spelled out the I (responsible for the Tripos) and short and medium term goals of Prior to taking over, I had been Prof Coen Teulings (responsible the Faculty and laid out a financial Director of Research and was for MPhil programmes) to carry basis for attaining them. The key the Founding Director of the out a wide-ranging reform of the objectives were to carry out world- Cambridge-INET Institute. I had teaching programmes. In 2017, leading research in the core fields also been involved in the setting Dr Pontus Rendahl and Professor of economics, to bring this research up of the Keynes Fund for Applied Robert Evans replaced Alexei and into the domain of applications Economic Research. These initiatives Coen, respectively. They brought and policy, and to educate the were part of a broader strategy to new energy to the tasks. As a result next generation of . The deepen the resource base and to of all this hard work, by 2018, attainment of these goals required a raise research aspirations of the student assessments had improved significant expansion in the number Faculty. My principal motivation for significantly: The Economics Tripos of high quality economists at taking over as Chair was the desire is now rated well above other Cambridge. to embed these initiatives on a Cambridge degrees. There has also more durable basis in the Faculty. been a significant improvement in The Faculty has invested heavily in the MPhil student evaluations. recruitment over the past 4 years: However, even before I had the seven new Lecturers and one new time to settle into my new office In the meanwhile, the work on Reader have been appointed. The on the first floor of the Faculty research and on the resource base new recruits have combined with Building, the Faculty faced pressing was proceeding alongside. Working existing faculty to greatly step up problems relating to teaching. closely with Professor Hamish the quality of research in the Faculty. The 2013 Learning and Teaching Low (responsible for Research) This is reflected in the publication Review revealed that students and Alexei and Coen, I prepared a of influential papers and books, in rated our Tripos and the MPhil Strategy Document and a Financial the number of high level workshops

4 “A key point in the Financial Plan was the proposal to deepen the resource base of the Faculty through philanthropic gifts.”

and conferences, in the visits by endowment income of the Faculty Over its long history, the Faculty many world leading academics and that was around £40K in 2010 has has had Alfred Marshall, Arthur policy makers, and in the award of grown to over £1.2 million by 2018. Pigou, , Joan a number of prestigious European Robinson, Richard Stone, James Research Council Grants to Faculty A key person in the project of Meade, Jim Mirrlees and Partha members. The rise in standards is deepening the resource base and Dasgupta, as its members. It has also visible in the large number of of raising research aspirations has been an honour and a great privilege internal University Promotions: we been the indefatigable Dr William to lead the Faculty and to help in have had one colleague promoted (Bill) Janeway. Through his many contributing to the continuation of to a Senior Lecturer post, seven gifts to us, Bill has become the most this great tradition. promoted to a Reader post, and important benefactor of economics three promoted to a Professorship. at Cambridge in its long and The role of the Chair comes with In achieving this success, the distinguished history. In addition to its surprises. But, looking back on Faculty has benefitted from the these gifts, Bill brings an intellectual these four years, what remains is sustained support from the senior passion and a level of commitment the memory of a period of intense management of the University. to new thinking in economics that camaraderie: there is nothing so inspired us to raise our efforts and rewarding as to work closely with A key point in the Financial Plan also to think afresh. He has acted extraordinarily gifted colleagues in was the proposal to deepen the as a mentor to me and has been a the pursuit of a shared vision. I am resource base of the Faculty through constant source of support to the grateful to Cambridge for having philanthropic gifts. Working closely Faculty. given me this opportunity. I know with Professor Giancarlo Corsetti that I have been very lucky. (Director of the Cambridge-INET All through my term, I have been Institute), Professor Christopher supported ably by the Senior Faculty In closing, I warmly welcome my Harris, and the University staff, Marie Butcher, Silvana Dean, good friend, Professor Hamid development office (CUDAR), we Emma Newman and Susie Wan. My Sabourian, as the next Chair of the Faculty. have made significant progress. personal secretary, Anne Mason, has By 2018, we have secured gifts in managed my schedule with great Professor Sanjeev Goyal FBA excess of £30 million. As a result, the patience and discretion. 29 September 2018

Cambridge Economics Issue 11 Autumn 2018 5 Economics Faculty Lectures 2017–18

The Education Production Function: A Brain Teaser

Marshall Lectures: Caroline Hoxby*

The brain’s capacity to gain and enhance cognitive skills continues to increase through to early adolescence.

hile recognising Gary increased to the point at which the abler students will gain more per Becker’s seminal marginal (social) cost is just equal to unit of schooling input than their contribution to the marginal (social) benefit, there less-able peers, and their unit cost of the concept of will still be marked differences in the schooling will be lower. Moreover, human capital and levels of individual achievement. as Hoxby’s own work shows, the Wits practical applications, Caroline relative gain, as measured by Hoxby’s work is transforming Hoxby shows that ability (she income differentials, is persistent our understanding of the huge prefers ‘cognitive skills’) can be through time. So, given successful potential that exists for increasing made plastic and that, by applying passages through college, higher the productivity of investment educational resources appropriately, ability students will, on average, in education. Becker’s standard the productivity of human capital have correspondingly higher life- education productivity function can be raised across the whole time earnings expectations. The (EPF) relates output (for example, of society, improving economic selective system is thus associated test grades or earnings gain) welfare and growth, and reducing with significant private and social to ability and to the amount of inequalities in opportunities and in gains from higher education and ‘schooling’ (usually measured in incomes. also with income inequalities. years). In the received analysis, ‘ability’ is genetically endowed, She starts by considering the US But, Hoxby asks, what does this fixed and unobservable. ‘Schooling’, Higher Education – Universities tell us about the productiveness conditioned by family background and Colleges – sector which over (or productivity) of the resource- and other controls, is the only direct much of its range reflects a market- intensive selective process? High variable by which to influence gain driven selective system in which ability students contribute heavily from education. Given variations in higher measured ability applicants to the costs of their education, innate ability, individuals will differ go to higher quality institutions whether individually or with the in achievements and earnings even that are resource-rich. If, as Becker’s help of their families and of college though the amount of schooling EPF assumes, education gain is endowments. But they also they receive is the same. Moreover, influenced by (genetically-fixed) consume educational resources if each individual’s education is ability as well as by ‘schooling’, then heavily. The process becomes

6 circular and self-reinforcing: well- potential to raise the gains from adolescence. As Hoxby points out, endowed colleges attract high education and training with little the irony is that school systems ability students who bring resources overall increase in resources. In turn tend to cut-back on resources at with them and, in due course, it would boost productivity in the just this stage in the education become high earners themselves, economy, at the same time reducing process: better teachers, by no doubt making donations and income inequalities. choice or because of professional endowments to their alma mater. responsibilities, tend to avoid Alongside Becker’s fixed-ability working with early adolescents; and Hoxby’s insight is to examine EPF, received wisdom in the subject specialisation often leads to productivity in terms of value economics of education emphasises pupils being taught in larger, rather added: she relates the individual’s the importance of early-years than smaller, classes. estimated earnings gain to the experiences for later education individual’s (marginal) social cost of achievements. Drawing on recent Hoxby’s assessment is that the the education resources consumed. developments in neuroscience, marginal return to education is high She finds that, across the student Hoxby shows that the brain’s in early adolescence; that school population as a whole in the capacity to gain and enhance systems should recognise this and selective system, ranging from cognitive skills continues to increase act on it; and that the scope for the poorly-endowed to the rich through to early adolescence, improving education outcomes, institutions, the pattern of unit gain around age 13½ years. The productivity, and economic growth in estimated earnings is essentially development of the brain’s frontal and welfare are immense. flat: high ability students gain more, lobe during this period is particularly but consume proportionately more important: it is the source of capacity resources in the process. for reasoning; planning; integration Tony Cockerill 6 August 2018 and self-control.

She then poses the crucial question * Caroline Hoxby is the Scott and Donya that is at the heart of her Marshall The outcome from this is that Bommer Professor in economics at Stanford Lectures: what if ability is not cognitive ability is not fixed and can University and director of the Economics of Education Program for the National Bureau of fixed but can be manipulated and be improved through appropriate Economic Research. Her research focuses on increased? This would have the education interventions in early issues in education and .

Cambridge Economics Issue 11 Autumn 2018 7 Economics Faculty Lectures 2017–18 Marshall Lectures: Caroline Hoxby*

The Narrow Corridor to Liberty Professor James Robinson*: The 2017–18 Sir Richard Stone Annual Lecture

James Robinson is probably most well-known for his long-time collaboration with Daron Acemoglu, in particular, their popular book “Why Nations Fail”. His Sir Richard Stone Lecture, also co-written with Daron, concerned their investigation of the causes of why the comparative development of countries can differ so fundamentally. The emphasis of the Lecture, though, was on political rather than economic development and is the subject of their new book.

he particular interest is an have both a strong state and civic be becoming too powerful. But attempt to understand society. The Lecture attempted to sometimes society is not sufficiently why different parts of the reconcile these disparate polities. strong to resist a charismatic leader, world end up with different e.g., Mohammad, Kamehameha or institutions and their Many historic examples illustrate Shaka Zulu. Tvariation across different states. To these contrasts. Gilgamesh, King of do so James used a super-stylised Uruk, created a rich and powerful Some countries are able to enjoy taxonomy based on a comparison city but at the expense of crushing and sustain a virtuous balance of the relative strengths of state civic society. The solution to his between state and society. To and society (see chart). Leading overweening power was to create explain the dichotomy between illustrative examples used were Iraq a “doppelganger” Enkidu to provide state and society James invokes and Liberia, very weak states unable the “checks and balance” thereby to a phase diagram for the power of to ensure the basic provision of give Uruk peace. This example was the state against that of society. public goods such as education and juxtaposed by the use of witchcraft Importantly, he identifies a “corridor” security, and China, a very strong by Tiv in Nigeria which had no containing those countries enjoying state but with highly centralised state and ostracism by Athenians a productive interplay between societal control. In contrast many to discipline individuals or elites state and society which is not a countries in the West appear to who were thought to be or to knife-edge unstable equilibrium.

8 Power of the State Power

Power of Society

A highly stylised game-theoretic model structures to-day. This central claim of the “State and society describes the interaction of players (“civil Lecture is at variance with many others society” and “elite” as the state) and their in that, for example, a strong state need need not be in conflict over the surplus produced. Three not precede the creation of democratic stable equilibria result: a dominant but institutions or state and society need incompatible relatively weak state, a dominant but not be in incompatible opposition. The opposition.” relatively weak society and, finally, the Lecture and subsequent book will excite “corridor” in which a strong state is in considerable interest and debate, in balance with a strong society. particular, among those concerned with comparative political and economic Countries may move into and out of the development. “corridor”, Prussia being a case in point of the latter when after the Thirty Years Further details may be found at War the state became relatively strong. www.econ.cam.ac.uk/Stone Robinson argues that the initial conditions typically enjoyed by countries did not Professor Richard J Smith differ that greatly but the evolution of 31 July 2018 the relative strengths of state and society determines the particular institutional * Harris School of Public Policy, University of Chicago.

Cambridge Economics Issue 11 Autumn 2018 9 Economics Faculty Lectures 2017–18

Morality and the Market Keynes Lecture:

The first Keynes Lecture, sponsored and judgements that aim to power: this can lead to price by the Economics Faculty’s Keynes prescribe how the world ought gouging, which has negative effects Fund, was given by Professor Jean to be. Economics is a moral and on consumers and can compel Tirole, of the Toulouse School philosophical science, and therefore, contracts under duress. Imperfect of Economics on 1 March 2018. the concept of morality can, and markets also imply asymmetric His work covers a wide range of should, be applied to markets. information, where all parties do theoretical and applied economics: Since normative economics is used not have the information to be industrial organisation; regulation; in the making of public policy, able to make informed decisions. corporate finance; financial markets morality is at the heart of public Markets may also lack morality due and intermediation; organisational policy, and at constant debate. to internalities, which arise from the economics; macroeconomics and failure of individuals to pursue their banking; and psychology-based Are markets moral? Is the market own self-interest. The main cause of economics. He was awarded the just to put a price on goods and this is a lack of self-control – people Nobel Prize for Economics in 2014. services and sell them? Some say who smoke may not consider the market is essential for both the negative effects on their own This report of the Lecture has society and the government to health, but rather their immediate been prepared by three students function. Others question where gratification. Since it can be argued the line is drawn between goods that markets may be made less than of Economics on the 2018 with a price, and dignity. Kant’s moral by such market failures, policy International Spring Semester moral theory on dignity and price attempts to correct them by using Programme of Pembroke College: asserts that dignity has a value that regulation. Rachel Fisher, Vassar College; exceeds any price. There are certain Emmanuella Kyei Manu, Princeton goods and services that, it may be But, Tirole argues, individuals have University; and Samantha agreed, should not be put for sale the potential to base their moral Samoylenko, Wellesley College. and given a price – for example guidelines on less universal values babies for adoption, surrogacy, like emotion, belief-based disgust, The International Semester votes in an election. tradition, etiquette, respect for Programme enables high-achieving authority, and group loyalty. Such undergraduates from universities and Arguments for why some markets feelings are an unreliable source colleges worldwide to follow selected lack morality centre on failures of ethical inspiration that can lead parts of a Tripos as fully matriculated which limit efficient exchange to the condemnation of victimless members of the University. between consenting adults. One acts, like gay marriage. Moral such failure is the presence of assertions on others override Jean Tirole begins his discussion of externalities; where two parties’ people’s freedom and basic rights. morality and the market by making actions affect a non-consenting His view is that, despite what may the argument that economics is a third party – for example, pollution, be an individual’s moral stance, moral and philosophical science. child labour, voting, or the image markets do exist and there is no This is justified through the of another person. Another is benefit in pretending they do normative aspects of economics, imperfect competition, which may not. Instead, it is more important which are based on opinions give one party extensive market to focus on their regulation. The

10 alternative can be unregulated, be likely to engage in pro-social narrative appeals to moral precepts untaxed, underground markets, behaviour if they have a mixture of: by asking questions such as: ‘what which is more undesirable and high self-image; high self-control; if that person were you?’ or ‘what if potentially more dangerous. low cost of pro-social behaviour; everyone did that same thing?’ A and high perceived social benefit, negative narrative changes beliefs He develops a model for how perhaps together with a low initial by downplaying the harm of the individuals make the decision personal reputation that can be action, or by blaming others for it. to undertake a moral or pro- enhanced. social action. The factors that are In conclusion, Tirole outlines exogenous to his model are the There are several insights to be three pillars of society: creation of cost to the individual of the action, drawn from the model. First is value; accountability, and social its personal moral value to them, a decision of when to seek or responsibility. Value is created and their self-control. Part of the avoid moral choices; some might when individuals pursue their own benefit from the pro-social action be heavily influenced by image self-interest, as per Adam Smith. is an externality that spills over or reputation and behave ‘too Referencing Pigou, the State needs into society; each individual has an morally’ for their own sake. Moral to be held accountable to correct importance that they assign to their preferences can be elicited by market failure. Finally, since it is social image. Tirole models how directly asking the minimum difficult for the State to address all individuals make the decision to amount of money that an individual such failures, society must have a engage in pro-social behaviour by would require in order to take or good conscience and be willing to relating the individual’s net benefit reject a specific action. Second, act morally. from the action to its expected narratives can be used to influence value in society. An individual will individuals’ actions. A positive 14 August 2018

Cambridge Economics Issue 11 Autumn 2018 11 Renewing Economics

GDP – Grossly Distorted Picture? There is next to no sign of digitalisation in the economic statistics.

he rapidly growing interest externalities and resource depletion. work. The quality adjustment and in how to measure the These have been much debated – for product differentiation challenges economy, and in the example in the 2009 Sen-Stiglitz- make a compiler of the GDP deflator intricate details of how Fitoussi report – and then largely want to weep. These various economic statistics are ignored at least in terms of policy. measurement challenges mean constructed,T is both surprising and statistics might be a small part of revealing. For some decades now, Now, these old critiques are back the explanation for the ‘productivity economists have been cheerfully on the agenda. One reason is the puzzle’, the flat-lining post-crisis downloading GDP and other national lacklustre post-financial crisis recovery, productivity trend. accounts figures without giving much resulting in an absence of any thought to the statistical niceties. The real income growth for millions of These issues came to a head in teaching of national accounting in households. To many people, being the UK with the publication of the undergraduate curriculum has told the economy was fine because Sir Charles Bean’s independent faded away. of growth in GDP discredited the review of economic statistics, which figures, or at least the story being recommended a programme of work Yet in the past two or three years, woven around them. Indeed, the crisis for the Office for National Statistics the amount of academic research in also prompted some well-justified to respond to the measurement this area has ballooned – including scepticism about the apparent challenges old and new. It set up among economic sociologists as contribution of the finance sector the Economic Statistics Centre of well as economists. There is also to the economy, a contribution Excellence at NIESR, where I run the much wider public interest. I spoke increased by a methodology change ‘measuring the modern economy’ in the Cambridge series in this year’s implemented in the UK in 2008. programme. The excitement of Hay Festival to a lively audience of digital should not distract attention about 300, presumably normally The second reason is the digital from the older measurement more interested in literature than economy. Smartphones and challenges, and ONS is also in the in GDP. There have been many pervasive internet access are part of lead internationally in compiling popular books recently on GDP and everyday life and are transforming measures of natural capital. I hope economic measurement – many business models. Yet there is next to be taking forward research on the highly critical, so my 2014 GDP: A Brief to no sign of digitalisation in the measurement of natural and social But Affectionate History looks rather economic statistics. There has been capital in the near future, as well as kind to our key economic indicator no data collection on quite a lot of the continuing to explore whether a by comparison. There has even been new activities. There are acute forms mass production age accounting a high profile prize, the Indigo Prize, of classic dilemmas about innovation framework can function for the digital to encourage the development of – such as new goods problems in age – or whether in fact a different alternative approaches to economic price indices: for example, is the price approach is needed to help us codify measurement. of a camera the price of a camera or and understand the significant the much lower price of the app and structural economic changes we are Ever since the national accounts the chip inside a smartphone? Zero experiencing. were codified in the post-war years, priced goods like those we all access there have been some well-known online constantly pose problems for Diane Coyle criticisms of the definitions and measuring aggregate expenditure. 3 August 2018 conventions, including the exclusion Marketed activities such as travel * Dr. Diane Coyle is Bennett Professor of Public of unpaid work in the home, and agency are migrating across the Policy in the Department of Politics and the omission of environmental production boundary into household International Studies.

12 up on a frugal diet of neoclassical Public Policy, intended for those taking Better Economics microeconomics that is characterised economics as a minor, as opposed to a by limiting assumptions about major, subject for their course of study, teaching? CORE! self-interest, rationality, and full- has recently been published. employment equilibrium in which Economics is ‘not to economic efficiency and welfare Some of those who support the drive be seen through the are maximised. Marginal analysis for more relevance and empirical is crucial to this process. Market realism in the teaching of economics distorting lens of a failure, associated with third-party argue that CORE has not (yet) gone limited set of traditional impacts as a result of externalities far enough. In particular, it is asserted paradigms’. or with imperfect competition, can that the approach is still weighted be regarded as an inconvenience towards Pareto efficiency and market solutions. The very act of Diane Coyle, who writes opposite that needs appropriately-judged preparing data for analysis, it is said, on developments in the concept policy interventions so that the risks introducing implicit framework and measurement of GDP, is leading equilibrium of the elegant model can bias. CORE’s methodology, while the work of the newly-endowed be regained. From this perspective integrative, is said to lack pluralism: Bennett Institute for Public Policy macroeconomics is seen a relative different methodological approaches in the Department of Politics and newcomer, with little integration are excluded and issues such as International Studies. Diane is an between the Keynesian, Monetarist, power and politics; social class; and economist with wide experience in and evolving paradigms, and almost feminist economics are largely ignored. public service, in journalism and the none with microeconomics. Moreover, little heed is given to broadcast media, in the private sector, educational philosophy in the teaching and as an academic, most recently as Any disillusionment we may have of economics (see Mearman et al. Professor of Economics at Manchester felt about the standard economics 2017). University. She was made CBE in curriculum, as evidenced by textbooks the 2018 New Year’s Honours List for and lecture courses, was reinforced Diane, in addressing the charges of ’services to the public understanding of in dramatic fashion by the financial irrelevance and the over-weening economics’. crisis of 2008/09, about which Queen influence of the neoclassical paradigm, Elizabeth II asked: ‘Why did nobody demonstrates the diversity, complexity Diane is a founding contributor to the notice it?’ Economics was seen as and social importance of economic Curriculum Open-Access Resources being obsessed with mathematical research and shows how, within CORE’s in Economics (CORE) project. Led by models and analytical frameworks that framework, the issues of technological Professor Wendy Carlin of University had little, if any, relevance to major disruption, market distortions, and College, London, the CORE project economic, social, technological and appropriate public policy interventions aims to develop and provide free political issues. have a central place in economics access to material for an introduction teaching. She also notes critically to an integrated study of economics, The crisis triggered urgent action the gender gap in the economics so that the world can be seen ‘as to assist the public understanding profession (see Coyle 2018). it is’. Integration involves the use of economics by making clear the of real-world data and information complexity and relevance of current CORE’s programmes have been widely for student-centred exercises and research and by bringing introductory adopted – so far by more than one study that is not to be seen through study plans and textbooks up-to-date. hundred universities and colleges the distorting lens of a limited set CORE has been at the heart of this. Its worldwide. But not, to date, by Oxford of traditional paradigms, and which major text, The Economy, first published or Cambridge. relates to current regional and global as an e-book in 2014 and subsequently

up-dated, consists of 22 units which issues, such as environmental damage, Tony Cockerill exploitative power, and inequalities. bring together six themes: history, 21 August 2018 These issues require economics to be instability and growth; the global used alongside economic history and economy; inequality; environment; References cognate physical and social sciences in innovation; and politics and policy. The Coyle, D (2018). ‘In defence of the economists’. Prospect, April. order for them to be fully understood first unit is ‘The capitalist revolution’. and analysed, and for effective policy Diane’s main contribution has been Mearman, A, D. Guizzo and S. Berger (2018). measures to be developed. to ‘Innovation, information and the ‘Whither ? Evaluating the CORE project as a response to calls for change Critics argue that, as economists, networked economy’ (Unit 21). A in economics teaching’. Review of Political many of us have been brought second e-book, Economy, Society and Economy, May.

Cambridge Economics Issue 11 Autumn 2018 13 New Books

The Digital Revolution and the State: The Great Reversal

he Digital Revolution, now “The Digital turned on the hard-earned coexistence in process of transforming of markets with increasingly our capitalist economies as Revolution has democratic political processes. The profoundly as the previous political events of 2016 – the Brexit technological revolutions challenged the Referendum and Trump’s election – -T from coal and cotton through the capacity of the show how fragile that coexistence is, railroads and on to electrification - was subject to discontinuous shocks when sponsored in all of its particulars by state to buffer market outcomes overwhelm the the American state, specifically the U.S. its constituents capacity of governments to respond. Department of Defense. Now it has taken on a life of its own, no longer from its economic Even as recovery from the Great dependent on the sponsorship of the Recession establishes itself, the American state but rather attacking consequences.” extreme distributional consequences the authority of that state – and others of the Digital Revolution persist and - at multiple levels and along multiple dominate. While the digital giants dimensions, while also generating new in inequality not seen since before the extend their global reach across digital platforms that are disrupting Great Depression. markets, maintaining competitive ecosystem after ecosystem in the markets will require legitimate state market economy. This great reversal in the relationship engagement, even as it did when the between the state and the Digital second industrial revolution in the late th Directly through automation of work Revolution has been amplified by 19 century spawned monopolies and and, at one remove, through the radical the renewed deligitimization of cartels around the world and when the reduction of technological frictions the American state as an economic Great Depression smashed markets which, in turn, vastly increases the actor, following the transient role it and stressed democratic institutions to the breaking point. integration of international supply played in constructing a floor under chains for goods and services – the economic consequences of the including especially labour services - Global Financial Crisis (“GFC”). The GFC Dr. William H. Janeway and the integration of financial markets dramatically demonstrated that the 3 September 2018 and institutions, the Digital Revolution markets of the economy depend for has challenged the capacity of the continuity on institutions external to William Janeway is an affiliated member of the Faculty of Economics. His book, state to buffer its constituents from its the markets that command political Doing Capitalism in the Innovation Economy: economic consequences. Especially in legitimacy: central banks and courts, Reconfiguring the Three-Player Game between Markets, Speculators and the State, the Anglo-American world, it has also most notably. The survival and success was published in May 2018 by Cambridge contributed substantially to increases of capitalism through the 20th century University Press.

14 The Economics of Religion in India

Religious organizations may play a positive role in India’s socioeconomic development.

Sriya Iyer is a Janeway Fellow in where economic growth is higher, Economics and Affiliated Lecturer apparently because growth increases in the Faculty of Economics; and a inequality. As inequality leads to Bibby Fellow and College Lecturer at social polarization, religious doctrines St. Catharine’s College, Cambridge. become more extreme. But there Her research is broadly in the are also hopeful patterns as well, fields of development economics, for example women’s religious and economics of religion, demography community participation is on the and education; and her research rise, contributing to their welfare. also examines how economics Religious organizations, on balance, interacts with related social science may play a positive role in India’s disciplines. socioeconomic development.

Sriya published her book on ‘The An important issue is the role of Economics of Religion in India’ in religious education, especially the September 2018*. Here she discusses difficult question of how to reform the origins, methods, results and madrasa (Muslim religious schools) policy implications of her important organizations in seven Indian education in India in order to widen research. states; to reveal the many ways the teaching of science, computers religions interact with social welfare, and mathematics. How to balance use economic methods to study economic development and political religious education with the religion. Religion is not a popular conflict. The survey examines both teaching of secular subjects, as well target for economic analysis. Yet religious and non-religious service as how to provide adequate teacher the tools of economics can offer provision in India in areas such as training are important concerns for deep insights into how religious education, health, employment, food religious schools if these schools are Igroups compete, deliver social distribution, child-care, and other going to continue to be widely used. services, and reach out to potential areas. I document differences across converts—how, in daily life, religions religions in the provision of these While researching in this area of nurture and deploy market power. I religious and non-religious services, economics poses complexities study this in India, one of the most and how changes in these services and challenges to the hopeful religiously diverse countries in the might also be related to income researcher, nevertheless the power world. inequality and religious competition. of economics can be applied to help illuminate some of societies’ deepest- Growth, inequality, education, After India’s economy was liberalized held beliefs and dynamics. There is technology, and social trends both in 1991 religious organizations still much to learn about countries affect and are affected by religious substantially increased their like India and other pluralistic groups. My research project began provision of services, in some ways economies the world over. over ten years ago, and includes a breaching the gap left by inadequate * Sriya Iyer (2018). The Economics of Religion in survey of almost 600 Hindu, Muslim, state provision. My data indicate that India. Cambridge, Massachusetts: The Belknap Christian, Jain and Sikh religious religious violence is more common Press of Harvard University Press.

Cambridge Economics Issue 11 Autumn 2018 15 Current Research

Systemic Risk-shifting in Financial Networks The empirical evidence is that, in managing risk, banks form stronger financial connections to banks that face more similar exposures to themselves.

inancial organizations seek to housing market risks of financial organizations that could to hedge their exposures (2011, Financial Crisis Inquiry lead to this. by writing contracts Commission). with other financial In the empirical component of the organizations, whom „„ US investment banks used paper we exploit supervisory data Fbecome their counterparties. But monoline insurers to hedge from the German Credit Register to this generates a new source of their subprime mortgage examine interbank loans between risk. If one of their counterparties risk, but these monoline German commercial banks. This fails then this counterparty may insurers, through their asset provides a measure of the strength not make good on the contract, management and collateralised of the financial links between and the hedge may fail. Thus, if an debt obligation (CDO) arms, different pairs of commercial banks organization faces a source of risk increased their exposure to in Germany. We then consider the it is seeking to hedge, it is intuitive subprime mortgage risk at loan books of these banks, and see that it should seek a counterparty the same time (SEC, “Risk which banks lend to similar sets not exposed to the same risk. This Management Reviews of of firms. The loan book portfolio reduces the possibility that the Consolidated Supervised similarity of two banks is found insurance the hedging contract Entities,” internal memo to Erik to be strongly correlated with provides will fail when it is Sirri and others, November 6, the amount of interbank lending needed. Indeed, the conventional 2007, p. 3)1. between them. This provides wisdom is that for this reason some systematic evidence that financial organizations will prefer In an ongoing joint project, is consistent with the anecdotal counterparties with less correlated together with researchers at the evidence above---banks form underlying exposures. However, Bundesbank / University of Cape stronger financial connections there is anecdotal evidence from Town and MIT, we seek to better to banks that face more similar the financial crisis running contrary understand these phenomena. exposures to themselves. to this: First, we gather evidence to investigate whether the anecdotes In our theoretical model, we first „„ In the United States, over- are anomalies, or indicative of consider the benchmark case of the-counter (OTC) derivatives something more systematic. Having socially efficient financial networks trading was concentrated at found evidence suggesting the (which maximize the expected the five largest banks that were latter, we build a theoretical model sum of equity and debt value in among the most exposed to better understand the motives the financial system). A standard

16 way to do this, which we follow, are inefficient. We then consider similar exposures to themselves, is to consider what a hypothetical the equilibrium, strategic behaviour even though doing so increases benevolent social planner would by the banks. There are strong systemic risk. The intuition is that do. Our social planner faces a externalities in this environment. although this can prevent hedges fundamental trade-off. Connections When a bank takes on more risk, from working effectively, this only are essential for hedging risks and its counterparties suffer. These happens when the bank is already preventing failures from relatively effects are not internalized and failing and hence these losses are small shocks, but carry the risk would normally be expected passed onto debt holders. that these same connections act to inhibit efficient outcomes as a conduit for shocks and can from occurring in equilibrium. The practice of shareholders lead to cascades of failures after Surprisingly, despite the presence undertaking activities that pass large shocks. We show the social of these strong externalities, the risks onto debt holders is known planner optimally balances these efficient solution is an equilibrium in finance literature as risk-shifting. forces in two ways. First, the social when banks seek to maximise their This is a well known and studied planner avoids creating strong expected sums of equity-holder and phenomenon. The contribution links between banks facing similar debt-holder values. Banks cannot of the paper is to show that this exposures. Second, the social profitably deviate from these operates at the level of financial planner chooses a financial network efficient outcomes because of the networks, with important structure that exhibits “firebreaks.” interlinkages in the financial system- implications for systemic risk. Banks are grouped into clusters with --deviations increase the expected Risk-shifting motivates banks to strong links within cluster, enabling number of failures, and enough of correlate their failures with their them to hedge shocks, and with the resulting losses flow back to a counterparties, despite it creating systematic risk. only weak links across groups deviating bank through the financial that make sure that very large system for these deviations to be Matthew Elliott shocks create failures that are still unprofitable. Again though, this is at contained within each cluster. odds with the empirical findings. Dr Elliott acknowledges the contribution of his undergraduate Research Assistant, Luther The analysis of the social planner’s However, if banks instead maximise Yap (Hughes Hall), to this article. problem suggests that the expected equity value only, the correlations found in the empirical social optimum is unstable. In this 1. As an example, Merrill Lynch was heavily exposed to the part of the paper (and anecdotal case, banks seek to create strong subprime crisis and hedged that exposure by writing Credit Default Swap (CDS) contracts with monoline insurer ACA. evidence from the financial crisis), connections to other banks facing But, ACA was also long on the housing market and ended up being downgraded by S&P to junk status. Ultimately, Merrill was taken over by Bank of America.

Cambridge Economics Issue 11 Autumn 2018 17 Awards Obituaries

Professor Professor (1921 – 2017)

In the Queen’s Birthday Honours List Kenneth Arrow, who died last year aged implication of this is that government this year, distinguished Cambridge 95, is among the greatest economists of needs ethical standards in order to guide economist Dr Geoff Harcourt was the 20th century. His work and interests the process of social choice. This applies made a Companion in the General within Economics were wide and deep, in particular to the market mechanism, Division of the Order of covering in particular, social choice; risk and which can only function well when properly (AC). The AC is the highest order uncertainty; general equilibrium analysis, regulated. of the Orders of Australia. Geoff’s and public policy. citation is ‘for eminent service to Arrow was awarded the Nobel Prize for higher education as an academic While he spent most of his academic career Economics 1972, together with Sir John economist and author, particularly at Stanford, his Cambridge connection Hicks. In later life, Arrow became active in the fields of Post-Keynesian came as a Fellow of Churchill College, in in issues of ecological economics, with economics, capital theory and 1963-64, 1970 and 1986. It was during particular concern for the developing world. economic thought’. Currently at a shorter visit in 1973 that he met (now the University of New South Wales, Sir) . Both were working, Arrow first studied mathematics and Geoff has Emeritus appointments in independently, on aspects of John Rawls’; statistics before taking up Economics at Cambridge as Reader in Economics notion of the ‘Just Savings Principle’ (JSP), Columbia, where he obtained his doctorate. and Fellow of Jesus College. He which forms part of his utilitarian social After war service in the US Air Force (as came to Cambridge from the welfare function. This function favours a weather analyst and forecaster) and in 1955 maximising the expectations of the further graduate work, he took up a post in to work for his doctorate; he was a least advantaged groups in society; the Economics at Stanford in 1951. He moved full-time member of the Faculty of JSP has inter-generational implications. to Harvard in 1968, returning eleven years Economics between1982 and 1998. Encountering a fierce intellect, Dasgupta later to Stanford as Joan Kenney Professor He has written extensively on the found their intense debates ‘a terrifying of Economics and Professor of Operations work of Keynes, Joan Robinson, and experience’, despite it being cushioned Research, where he remained for the rest of other Cambridge economists and within a kind and humble persona*. his life. has made seminal contributions to our knowledge of income, capital One of Arrow’s later outstanding theoretic Tony Cockerill formation, profits and economic and empirical contributions is the so-called 4 September 2018 growth. ‘Impossibility Theorem’, which demonstrates * Professor Sir Partha Dasgupta’s tribute to Kenneth that no voting system is capable of leading Arrow, delivered at a Plenary Session of the Vatican’s Tony Cockerill unequivocally to collective decisions pontifical Academy of Social Sciences on 29 April 5 September 2018 that reflect the desires of individuals. An 2017 is at: http://www.econ.cam.ac.uk/events-files/ news/docs/KJA.pdf.

18 Professor Sir James Mirrlees (1936 – 2018)

James Mirrlees, who died in Cambridge Today’s undergraduates encounter on 29 August this year, aged 82, was one Mirrlees’ work particularly in optimal of the most outstanding economists of his taxation and in cost-benefit analysis. generation, much liked and respected as His work with of MIT researcher and teacher by both colleagues (himself a Nobel Laureate in 2010) on the and students. As an undergraduate, principles for optimal taxation led to the he read Mathematics at Trinity, having Diamond-Mirrlees efficiency theorem previously taken a degree in the same (1971). Recognising the inevitability of subject at Edinburgh. On graduation government taxation on commodities for he moved to Economics to work for general revenue purposes, the theorem his doctorate on economic planning, demonstrates that, in order to maintain under the supervision of Richard Stone. efficiency, the price distortions caused by Following government advisory work in taxation must fall not on the production Swaziland and Pakistan and a further spell side of the economy, but rather on in Cambridge, in 1968, aged 32, he was consumers. appointed Professor of Economics and Fellow of Nuffield College at Oxford. In cost-benefit, Mirrlees’ work at Nuffield with Ian Little on ‘Project Appraisal and He returned to Cambridge and to Trinity Planning for Developing Economies’ (1974) as Professor of Political Economy in remains the foundation for investment 1995. On retirement from his Cambridge appraisal – and not only in the context of post, he became the Founding Master economic development. of Morningside College in the Chinese University of Hong Kong. Mirrlees received A full appreciation of Mirrlees and his the Nobel Prize in Economics, jointly with work will appear next year in Cambridge , in 1996. The citation for Economics. the award was for his work in ‘’. He was knighted in 1997. Tony Cockerill 5 September 2018

Cambridge Economics Issue 11 Autumn 2018 19 Comings and Goings

We welcome

Two new University Lecturers:

Dr Noriko Amano Patino from Yale. Noriko’s specialisms are in Labour Economics and Applied Econometrics. She completed her doctorate with a dissertation on ‘Dimensions of Inequality’, looking particularly at household diets and nutrition; Affirmative Action legislation and wage outcomes; and influences on the widening gender wage gap.

Dr Weilong Zhang from the University of Pennsylvania. Weilong works in the fields of Labour Economics, Education Economics, Family Economics and Psychology Economics. His recent publications are on the effects of local and universal minimum wage policies, and on the relationships between personality traits, household bargaining weights and Recent promotions wage outcomes. have been

As Professor: Dr Vasco Carvalho The Pitt Professor for 2018–19: As University Reader: Dr Tiago Cavalcanti; Dr Professor Naomi Lamoreaux. Naomi is visiting Meredith Crowley; Dr Matthew Elliott; Dr Sara from Yale, where she is Stanley B. Resor Professor of Horrell and Dr Pontus Rendahl Economics and Professor of History. Her work is on US Economic, Business and Technological History. As University Senior Lecturer: Dr Petra Geraats Her current research interests include patenting and the market for technology in the late nineteenth and twentieth century U.S., business organizational forms and contractual freedom in the U.S. and Europe in the nineteenth and twentieth centuries, the public/ We say many thanks and private distinction in U.S. history, and the rise and farewell to decline of innovative regions. Professor Hamish Low Professor Coen Teullings

Contact

Editor: Faculty of Economics Professor Tony Cockerill Editorial Team: Austin Robinson Building Toke Aidt, Edoardo Gallo, Craig Langton, William Peterson, Sidgwick Avenue Richard Smith, Susan Wan Cambridge CB3 9DD

[email protected] www.econ.cam.ac.uk